Flattening Yield Curve Isn’t Just The Fed’s Problem

April 22, 2018

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The flattening U.S. yield curve, a harbinger of possible economic
trouble, has caught the eye of officials at the Federal Reserve. But a
potential problem for the Fed is a worry for the rest of the world,
too—especially the European Central Bank.

An inverted U.S. yield curve—where short-term
rates rise above long-term rates—has a strong track record of being a leading
indicator of recession. Last week, the gap between two-year and 10-year U.S.
Treasury yields reached its narrowest since 2007, below 0.5 percentage point.
If it were to continue flattening, the curve could invert later this year or
early in 2019.

In addition, swaps measuring U.S.
interest-rate expectations for 2021 have edged below those for 2020, notes
Deutsche Bank, showing investors are thinking about the Fed cutting rates, not
just raising them.

All that might sound a long way off for
anyone else to worry about particularly.

But the timing matters because the ECB has
locked itself into a very gradual path from exit. It isn’t expected finally to
wind down its bond purchases until the end of the year. Rates are likely to
rise only slowly after that. By 2020, the ECB might only just have exited its
negative-interest-rate policy.

It is, of course, easier to tighten policy
when the growth outlook is good. If the yield curve continues to flatten,
however, and markets grow nervous about a hit to U.S. growth, that might at the
least complicate the ECB’s taskin exiting ultraloose policy. A U.S.
downturn will undoubtedly affect Europe.

And if a real downturn were to emerge in the
U.S.—Société Générale is forecasting a mild recession in 2019-2020—and spill
over elsewhere, then a debate would start about what tools central banks had
left. While the Fed now has some room to cut rates again, the ECB might be
grappling with inventing new ways to provide stimulus.

True, there is plenty of debate over what message the U.S. curve is actually
sending and how flat it is. UBS argues global quantitative easing has distorted
long-term bond yields by reducing the term premium, or the extra yield
investors demand for uncertainty about monetary policy.

But if investors fear a U.S. slowdown or
recession and pull back from taking risk, that will tighten financial
conditions. The ECB is trying very hard not to spook investors. Reaching the
exit may be the bigger challenge.